The following chart is sourced straight from the RIAA year end sales report. It is released every March, and it is the reason you read about the year-over-year triumphs of digital downloads in the face of plummeting CD sales. It is the reason everyone knows that the physical format is dead, the music industry was slow to respond to P2P, and the industry-wide contraction was their price to pay… yada yada yada, I’m not here to beat that dead horse (yet).

It’s not the #s that interest me; they’re all predictable data points continuing a decade long trend. No, I’m more interested in the format of the chart. Ever since about 2004, the RIAA has formatted their year end sales summary in the same binary digital / physical layout.

It’s a false dichotomy. Digital downloads share a lot more in common with physical media than the music industry might hope for. And that’s bad news for the major labels in general. Here’s why:

“Units” Are Becoming Obsolete Even if it’s delivered over TCP/IP, the selling and downloading of song files is a vestigial consumer behavior leftover from the physical media era. Consumers are still transitioning out of the idea of “owning” their music, and downloads happened to be that natural and convenient next step in the “digital” age.

But the clouds are forming, and the storm is bound to rain (apologies for the blatant metaphor). Between Youtube, blogs and Spotify, you can already find just about any song you could possibly want to hear. Anecdotally I hear more and more kids who can’t be bothered to download anymore - the gratification is so much more instant on YouTube. Increasingly, the main value of buying or pirating an MP3 these days is that it’s a mode of cataloguing a personal music library (and sloppy one at that). Even this distinction is eroding under the increasing maturation of cloud music.

And so it follows that…

Digital downloads will plateau in 3-5 years It’s easy to ignore the impending free fall that’s going to happen in the record industry. After all, digital download revenues continues to see double digit year-over-year growth. In fact, in the next year or two, we should see digital download revenues top CD revenues for the first time. At about which time we should expect the industry press echo chamber to renew the hopeful charge that people can and will continue to buy music.

But again, both pirated and legal downloads will continue to drown under the clouds. Given the quickening advance of the clouds and the generational turnover of music’s primary consumer (i.e. young people), my guess is that the legal digital download market will peak soon after it laps the CD in overall revenues.

When digital downloads peaks, that’s when the recorded music industry will truly trip into a free fall of diminishing returns. And sure, the subscription model has yet to hit its hockey stick, and we haven’t seen the full potential of digital performance royalties (i.e. internet radio). But even if overall streaming revenues match “moving units” revenue, the transactional structure of those models are fundamentally worse for the record industry, because….

When Plays Replace Products, Labels Lose Leverage With the recent successes of Spotify, you’re starting to find more stories like this, this and this, that attempt to calculate the amount of subscription plays it takes to equal a download purchase. The most optimistic scenario has a paid subscriber listening to an artist’s song anywhere from 25-60 times to equal the takeaway from 1 paid download. With only 1.3 million paying subscribers in 2011, most subscription listens come from free users, who need to play a song anywhere from 80-300 times to equal the takeaway from 1 paid download.

Sure, these numbers are in the realm of possibility for any given addictive song, but that’s not the point. CDs and paid downloads meant you had your fans pay up front, thereby guaranteeing an inflated threshold per piece of “sold” content. This transactional dynamic is inherent when you’re moving units, physical OR digital.

When we get to a sophisticated access/subscription model, artists and right holders aren’t charging their fans directly for a discrete product, but instead pandering for their plays.

This is a significant shift, and undermines much of how labels have been operating over the decades. Labels are in the business of selling product directly to consumers. The digital download is an extension of that. But when the imperative is plays, the leverage and interests of right holders changes. The threshold value of any piece of recorded content, lowers. The play becomes conceptualized as currency, and other connected actions from fans — like social media favors, emails, and perhaps most importantly, as traffic bait for direct-to-fan products — are suddenly a lot more attractive objectives for any given song launch.

Point being, right holders will be less interested in guarding their songs for sale when selling is not the point.

And So…

All this is not to say that the music industry as a whole is doomed. My ultimate point is that when recorded content becomes un-productized, it ups the viability of other types of direct-to-fan products.

Currently, “direct-to-fan” in the music industry primarily means they’re going to email fans to buy the next album. That’s a superficial application of direct-to-fan.

I want to save my hypothesis on what the next “music industry” product will become for future posts, but I think it helps to think about some of the more creative tiers of support you’re starting to see from artist Kickstarter projects. Think tiered, high margin products that emphasize some sort of direct, relationship-based access to artist. These are the types of authentic “experiences” you can sell online, without worrying about piracy (short of cloning the artist). It’s this sort of fan based patronage that may fund a veritable renaissance of artistic creativity in the 21st century.

Or not. Either way, we’ll find out when iTunes becomes obsolete.

(EDIT: This post is reposted from my former blog, trackswell.com. It’s since been reposted by Hypebot. The Hacker News discussion is here.)